Peloton Wound Down

At the 2007 EuroHedge awards Ron Bellar and Geoff Grant, co-founders in 2005 of Peloton Partners, received the awards for best new fund of the year and best credit fund. Fast forward one month to last Thursday and Peloton warned investors that its recent bet on AAA securities went sour. On Friday Reuters reports that assets in Peloton's $2 billion ABS master fund have been seized by lenders and are being liquidated:

Several U.S. lenders have taken control of failing hedge fund Peloton Partners' assets, one day after the fund said it was liquidating a portfolio, a person familiar with the situation said on Friday.

Some banks are taking matters into their own hands, while others are being more patient and are cooperating with an orderly liquidation, said the person who was briefed on the matter but who is not authorized to publicly speak about it.

Peloton has also frozen redemption on its smaller multi strategy fund:

Peloton has a second fund, the Multi-Strategy Fund, whose fate remained unknown after redemptions were suspended this week.

Peloton gained 87% in 2007.

The Financial Times reports that Bellar and Hunt were both heavily invested in the fund and stand to lose a substantial amount of their personal fortunes. As expected, the culprits were leverage and margin calls:

The $2 billion or so of equity in the fund was constantly leveraged four or five times over, giving the fund a portfolio of assets worth some $9 billion. The high-quality mortgages in Peloton’s portfolio were used as collateral to back the leveraged positions.

I would venture that both leverage and margin calls are not the root problem, but rather the catalysts. Peloton was holding "AAA" rated securities which were rapidly losing value. Since highly leveraged, this was eating into their capital base at an alarming rate, thus precipitating a blow up.

Citadel to The Rescue?

In an interesting turn of events, Chicago based hedge fund Citadel has declined to bid on Pelotons distressed book:

When it became clear that hedge fund Citadel Investments Group, which rescued ailing portfolios from Sowood Capital and Amaranth in the past, had no interest in Peloton, some lenders got even more nervous and took the assets back, a person said.

This could indicate that the book is not as solid as Peloton thought, or that Citadel itself is capital constrained. The current market turmoil as well as any further deterioration (which I expect) is going to present excellent opportunities for well capitalized and savvy investors. Citadel, for one, has been building quite a reputation so I am very curious why they declined to bid. It is possible they are being cautious as they expect further deterioration or are, at least, uncertain of the fundamental value of the book. The most important variable for distressed debt in the coming years is going to be solid fundamental analysis guided by a good grasp of the macro environment. The macro environment currently is very uncertain.

No LTCM

Doug Noland over at prudent bear discusses this story in his latest credit bubble bulletin. He argues that Peloton's experience, although similarly driven by a highly leveraged book, is vastly different from the LTCM crisis:

This is No LTCM. The current financial and economic backdrop is altogether different. Speculators that would typically seek to capitalize on depressed securities prices now confront enormous uncertainties. How bad will things get in California, Florida, and elsewhere? How many will walk away from underwater mortgages – for starter homes and million dollar-plus California bungalows? How badly will the U.S. “services” economy be hit by housing and financial woes? How bad are the unfolding Credit problems in state and local finance? Will pinched consumers also turn their backs on Credit card, auto and student loans? How long will the seizing up of the securitization markets last? How will corporate Credits hold up in the event of prolonged Credit restraint and economic tumult? What are the ramifications if the “monolines,” GSEs, private-label MBS/ABS, the Credit derivatives marketplace, and Wall Street “structured finance” (more generally) don’t recover? None of these pertinent questions were even remotely contemplated or relevant in 1998.

I agree with Mr. Noland 100%. There are simply too many variables for a fundamental analysis to establish any reasonable margin of safety. One needs to have a firm grasp on the macro environment, which is currently too murky.

Systemic Crisis Not Tail Risk

The problem today is that the Fed fueled a speculative real estate bubble that was supported by bad incentives in the credit markets. Not only did this cause dislocations in the production structure, it resulted in risks being shifted to yield chasers who perhaps did not fully understand their exposure. As I understand it, the problem in 1998 was different in that LTCM sold a bunch of tail risk and was hit by a "100-year flood". Due to immense leverage LTCM's equity base eroded quickly and they could not ride it out. Peloton too was leveraged, but they did not sell tail risk. Neither has the recent trouble in quantland been tail risk. Of all the funds that have recently blown up, it seems like most were playing with risks they didn't understand; not merely selling tail risk. It would thus appear that the current crisis is a systemic issue. Subprime, being the weakest sector, was the first crack. The cracks have since spread to structured products at large. Muni's are currently showing strain. Jan 25th seems to have marked the turning point for them.

I believe this is a systemic crisis that cannot and will not be contained. Since capital markets are an integral part of the allocation of resources towards productive enterprise, any tightening of credit will have a very real effect on the economy. If the US is not already in a recession, I expect one in the near future.